The Mongolian economy has made a remarkable turnaround fueled by investment in the mining sector and rebound of copper and coal prices, following a sharp drop in the output in late 2008 and early 2009. The 18-month Stand-By Arrangement (SBA) for Mongolia completed successfully in October 2010. The 2011 Article IV Consultation took place against the backdrop of such a strong recovery and emerging signs of overheating. Discussions focused on the policies for avoiding a return to the boom and bust policies of the past and for ensuring the country’s huge mineral deposits lead to sustainable and equitable growth. The authorities concede the risks to the outlook and share the staff’s policy advice. They are trying to respond preemptively to rising inflation and capital inflows through fiscal, monetary and macro-prudential policy measures accompanied by structural reforms.
Growth rebounded strongly in 2010 to 6.1 percent, following an outturn of minus 1.3 percent in 2009. The 2010 growth is a lot more impressive, given the fact that the last year’s devastating winter conditions (a so-called “dzud”) wiped out almost one-fourth of livestock. The shock to food supply, however, drove inflation into double digits, with January data showing a rise in the headline inflation to 14.8 percent year on year, following 14 percent increase in the previous month. Higher copper prices and surging coal exports to China have helped boost net international reserves to an all time high.
This year’s growth is projected to accelerate to around 10 percent, driven by the construction of the Oyu Tolgoi copper mine and related infrastructure projects, as well as base effects favorable to agricultural sector, accounting for over 20 percent of GDP. On the inflation front, the staff expected that inflation could reach 20 percent by year-end due to a combination of rising global food prices, expansionary 2011 budget, including cash handouts to the population, and mineral sector boom. On the other hand, the authorities expected that inflation might remain within 12 to 20 percent range, while they understood the high risks to inflation. They are planning to update their inflation forecast and adjust the scope and pace of policy response after confirming the inflation data of early months of 2011. The most recently released inflation data is 10.9 percent for February on a year on year basis.
2011 Budget. The 2011 budget approved 35 percent increase in nominal spending. The staff claimed that the large increase in spending would do more economic harm than good through higher inflation and crowding out private sector activity. The authorities acknowledge that such an expansion of government expenditures may have negative effects on macroeconomic stability. However, they view that they have made their efforts to secure medium-term fiscal sustainability under inevitable political pressure on spending increase, which had largely been incurred by the promise of the previous election campaign. Furthermore, the authorities are planning to amend the 2011 budget to secure more fiscal restraint if inflationary risks are aggravated. They are also committed to meeting the numerical target for structural budget deficit of 2 percent of GDP in 2013. When considering that universal cash transfers are increased by around 4 percent of GDP in 2011, and that those cash transfers will be expired after the 2012 elections, they have ample room to achieve the needed fiscal adjustment.
Medium-term Fiscal Framework. The adoption of the Fiscal Stability Law (FSL) last year was a landmark achievement for avoiding the boom and bust policies of the past. The staff assessed that the 2011 budget could be a big step backward and it could undermine the law’s credibility. On the other hand, the authorities indicated that they are still committed to observing the FSL to enhance medium-term fiscal credibility and sustainability. They have tried to balance the economic and political considerations under the great pressure to show tangible benefits from the signing of the Oyu Tolgoi investment agreement in the aftermath of the hardship from the crisis. As shown in Debt Sustainability Analysis (DSA), Mongolia remains low risk of debt distress supported by a bright medium and long-term macroeconomic outlook, and public debt ratios are projected to fall steadily from 2011. In addition, the authorities have greatly improved debt management through introduction of internal audits, clear separation between monetary policy and debt management, and information sharing between the Ministry of Finance and the Bank of Mongolia.
Structural Fiscal Reform. Mongolia has made significant progress in improving budget transparency, but there is still a considerable room for improvement in public investment management. Several draft laws on public finance issues – the Integrated Budget Law and the Law on Development Policy and Planning, and a revised Law on Public Procurement – are under discussion, and implementation of public-private-partnerships (PPPs) is being considered. The authorities also plan to establish a Development Bank during this year. The bank will use a portion of the proceeds from the Fiscal Stability Fund to finance the country’s essential infrastructure needs. The authorities concur with staff that PPPs and the Development Bank should not be used as a measure to increase off-budget activities and should be set up based on international good practices and transparency. On the other hand, the approval of the Social Transfer Reform Law, which was submitted to the parliament last year, will substantially strengthen the social safety net through introduction of a more targeted poverty benefit transfer system.
Although the Bank of Mongolia well recognizes the threat of escalating inflation, there are some limits to what monetary policy can contain inflation, given the substantial increase in fiscal spending and considerable pressure of capital inflows. The staff assessed that the crowding out effect of higher interest rate, while undesirable, would be better than the alternative of allowing inflation pressures to build up further. They supported giving the central bank a more explicit mandate to make inflation the primary objective of monetary policy. The central bank has sought to strike the right balance between various measures in its toolkit for combating inflation and managing capital inflows, which includes increasing reserve requirements of banks, raising the policy rate, and allowing greater exchange rate flexibility. In its meeting at the end of February, the Bank of Mongolia Board decided to keep the policy rate unchanged and increase the rate of reserve requirements by 400 basis points to 9 percent in order to tighten monetary policy stance and strengthen the banking sector’s risk-resistance.
Exchange Rate Policy
The central bank has been trying to dampen excess volatility in exchange rate stemming from large and volatile capital inflows. The real appreciation of the Mongolian currency (MNT) last year was about 20 percent, which was helpful in reducing inflation. The exchange rate has been fairly stable this year, and foreign reserves have been maintained at an all time high. The authorities concur with staff that the flexible exchange rate regime will continue to be appropriate for the Mongolian economy, in terms of containing inflationary pressure and providing a buffer to external shock. At the same time, they are looking for structural ways to enhance the absorptive capacity of the economy and harness capital flows to support productive investment and potential growth through deepening financial markets and strengthening the institutional framework.
Indicators for banking system health have improved and bank loans as a share of GDP has declined since the 2008 crisis thanks to a strong economic recovery, but NPLs and loans in arrear still stand high. While real interest rates on deposits are falling, MNT deposits continue to rise, fuelled by currency appreciation expectations under the blanket deposit guarantee system which was adopted during the crisis. At the same time interest rates on US dollar deposits are high, with time deposits offering rates reaching 14 percent, reflecting the continued perception of risk in the market.
The framework for banking supervision and restructuring has been strengthened as part of structural benchmarks under the SBA. The authorities are moving ahead with strict enforcement of prudential regulations against any banks that are not in compliance. A prompt passage of the Empowering the Banking Sector and Capital Support Program will offer a transparent means to provide a temporary financial support to the bank that needs time to come into full compliance. While fully agreeing with the importance of a speedy legislation to make progress in restructuring banking sector, the authorities admitted that their fragmented decision-making system and the turnaround of economic situation could cause some delay in executing reform measures.
The Mongolian economy has a bright economic future, as development of the mineral sector will lead to a substantial growth and an opportunity to spread benefits from resource wealth to all Mongolian people, without harmful effect from “Resource Curse”. According to staff’s projection, per capita income of Mongolia will almost quadruple in 8~10 years, from current amount of just above US$2,000, based on rapid growth in mining sector and currency appreciation. Such prosperity, however, is not guaranteed. The Mongolia’s recent crisis illustrates that so-called “Resource Curse” could not be ruled out. Increasing public awareness of such risks would be helpful in controlling excess demands from the people and focusing on macroeconomic stability in the long run.
Although Mongolian economy has succeeded in rapidly recovering from a severe downturn due to the global financial crisis and the country’s medium-term prospects are much favorable, the pro-cyclical fiscal stance in the pre-election period and ailing momentum for institutional reforms are challenging the authorities’ policy framework. The authorities admit that they have been recently under pressure to increase government spending, when the build-up fiscal financing constraints were alleviated by higher resource prices and a substantial payment from a major mining development project. The authorities remain, however, committed to continue implementing sound macroeconomic policies and a broad range of structural reforms. They are keenly aware of future opportunities and challenges from their abundant resource deposit. The Mongolian authorities, therefore, request continuous engagement and policy advice of the Fund to strengthen macroeconomic stability and sustain high growth with low inflation for poverty reduction and job creation, with keeping imminent overheating pressures in check.